Wrapped Tokens: How They Work, Where They Are Used, and What Risks They Carry

Wrapped tokens make it possible to use assets from one blockchain ecosystem in another. They allow liquidity from BTC, ETH, BNB, or SOL to be integrated into DeFi protocols and other applications that do not directly support the original asset.

A wrapped token is not the original asset itself, but a tokenized representation of it. In most cases, its purpose is to maintain a value linked to the underlying asset while making that value available within a different technical environment.

How Wrapped Tokens Work

The classic model works as follows: the underlying asset is locked in a specific system, and a corresponding amount of wrapped tokens is issued. In most cases, the conversion is maintained at a 1:1 ratio.

For example, when WBTC is issued, a user deposits BTC and receives an equivalent amount of WBTC. The original BTC remains in the underlying reserve, while WBTC can be used across networks and applications that support the token. WBTC is designed to maintain 1:1 backing with native BTC, with reserves verifiable through a Proof of Reserve mechanism.

However, the backing mechanism depends on the specific wrapped token. In some systems, the underlying assets are held by custodians, while others rely on smart contracts or protocols with a particular set of participants. That is why it is important to understand not only the token's price but also what actually backs the tokens in circulation.

It is also important to distinguish between the wrapped token and the original asset at the technical level. 1 WBTC and 1 BTC may have nearly the same value, but they are different assets. BTC is the native asset of the Bitcoin network, while WBTC represents BTC within another blockchain infrastructure. Their values can remain closely aligned through the backing mechanism, but they are not technically the same asset.

The reverse process is known as unwrapping. The user returns the wrapped tokens to the relevant system, where they are burned or otherwise removed from circulation, and the underlying asset is released and returned to the user. In the case of WETH, for example, ETH deposited into the smart contract is locked, while WETH is burned during the redemption process and the corresponding amount of ETH is released.

Where Wrapped Tokens Are Used

The main purpose of wrapped tokens is to move liquidity between blockchain ecosystems. An asset that originally exists on one network can gain access to another network's infrastructure and applications.

Wrapped tokens are particularly important in DeFi. They can be used on decentralized exchanges, in lending protocols, liquidity pools, and various yield-generating strategies.

For example, WBTC allows BTC to be used as collateral, supplied to liquidity pools, or deployed in other DeFi applications. WETH is widely used in trading pairs and applications built around the ERC-20 standard.

In this sense, wrapping does not necessarily create a new economic asset. Instead, it makes existing liquidity compatible with another blockchain environment.

Popular Wrapped Tokens

Some of the best-known examples include:

• WBNB - a wrapped version of BNB used as a BEP-20 token within the BNB Smart Chain ecosystem. BNB is the network's native asset, while WBNB allows it to interact with applications built around the BEP-20 standard.

• WETH - a wrapped version of ETH used on Ethereum and across various L2 and other EVM ecosystems, including Arbitrum, Base, and Polygon.

• WSOL - a tokenized form of SOL within the Solana ecosystem that allows SOL to interact with the Token Program.

The same name does not always imply the exact same technical implementation. Different networks can have different implementations of wrapped assets, so users should always verify the token address and the specific protocol that issued it before using a wrapped token.

Why Is WETH Needed on Ethereum?

ETH is the native asset of Ethereum. It exists directly at the protocol level and is used, among other things, to pay for gas.

The issue is that ETH itself is not an ERC-20 token. Meanwhile, many DeFi protocols and decentralized applications are designed to interact specifically with ERC-20 tokens.

WETH solves this technical limitation. A user deposits ETH into a smart contract and receives an equivalent amount of WETH, an ERC-20-compatible token. This allows WETH to be used in applications that operate with the ERC-20 standard.

WETH can be converted back into ETH at a 1:1 ratio when needed. The WETH is burned in the process, and the corresponding amount of ETH is released from the smart contract. However, native ETH is still required to pay for gas - WETH cannot be used for this purpose.

WETH therefore does not replace ETH. Its purpose is different: it represents ETH in a format that is easier for smart contracts and DeFi applications to work with.

Risks of Using Wrapped Tokens

Wrapped tokens add another layer of complexity, and with it come additional risks.

The first is custodial risk. If the underlying asset is held by a third-party custodian, users depend on that custodian's ability to safeguard the reserves and return the assets when needed. Hacks, frozen funds, technical problems, or bankruptcy could create difficulties when redeeming wrapped tokens.

The second is smart contract risk. If the issuance and redemption of tokens are controlled by smart contracts, a coding error or vulnerability could result in lost funds or disrupt the backing mechanism. Even WETH, which relies on a relatively simple and well-established smart contract, remains a token whose operation depends on code.

The third is depegging risk. A wrapped token is generally expected to maintain a value close to that of its underlying asset, but its market price can temporarily deviate. Problems with reserves, liquidity, or the redemption mechanism can make such deviations more pronounced.

Finally, it is important to remember the fundamental difference between a wrapped token and the original asset. 1 WBTC is expected to be worth roughly the same as 1 BTC, but WBTC is not technically BTC. Likewise, WETH represents ETH in an ERC-20-compatible format, but it is not native ETH.

Wrapped tokens have become an important part of crypto infrastructure because they allow liquidity to move between networks and make existing assets usable across DeFi. But this convenience comes with a trade-off: the security of a wrapped token depends not only on the underlying blockchain, but also on its backing mechanism, smart contracts, custodians, and the broader infrastructure connecting the token to the underlying asset.